Federal Tax Consequences of Ordinary Transactions in Real Estate Robert E

Marquette Law Review Volume 60 Article 3 Issue 1 Fall 1976 Federal Tax Consequences of Ordinary Transactions in Real Estate Robert E. Meldman Nelson S. Weine Follow this and additional works at: http://scholarship.law.marquette.edu/mulr Part of the Law Commons Repository Citation Robert E. Meldman and Nelson S. Weine, Federal Tax Consequences of Ordinary Transactions in Real Estate, 60 Marq. L. Rev. 61 (1976). Available at: http://scholarship.law.marquette.edu/mulr/vol60/iss1/3 This Article is brought to you for free and open access by the Journals at Marquette Law Scholarly Commons. It has been accepted for inclusion in Marquette Law Review by an authorized administrator of Marquette Law Scholarly Commons. For more information, please contact [email protected]. FEDERAL TAX CONSEQUENCES OF ORDINARY TRANSACTIONS IN REAL ESTATE ROBERT E. MELDMAN* and NELSON S. WEINE** I. INTRODUCTIONt The final consequences of a transaction in real estate, no matter how common or extraordinary, can differ substantially as a result of its tax effects. Some of the greatest tax catastro- phies often occur in the day to day transactions of buying, selling and renting real estate. Thus, for purposes of guiding one's client to the best results, it behooves the practicing attor- ney to become as familiar as possible with the tax laws which can affect the outcome of a transaction in real estate. II. How TITLE SHOULD BE TAKEN IN ACQUISITION OF REAL ESTATE One of the most important problems facing a taxpayer who plans to acquire real property is the form of ownership in which he should take title. The taxpayer may find that the tax consequences of the various forms of ownership will have an important bearing on his decision. Therefore, an analysis of the forms of ownership and their tax consequences must be considered. A. Individual Ownership If an individual holds title to trade or business property or to property held for the production of income, he must report the gross income from the property on his federal income tax return for the year in which the income is received or accrued. Correspondingly, he is entitled to deduct all of the expenses with respect to the property, including an allowance for depre- * B.S. 1959, University of Wisconsin; J.D. 1962, Marquette University; L.L.M. (Taxation) 1963, New York University; member, Meldman Limited, Milwaukee, Wis- consin; Lecturer in Taxation, University of Wisconsin-Milwaukee; Lecturer, Mar- quette University Division of Continuing Legal Education, Taxation of Real Estate Transactions; member of the American, Wisconsin and Milwaukee Bar Associations. ** B.A. 1965, University of Miami; J.D. 1968, Ohio State University; L.L.M. (Tax- ation) 1972, George Washington University; associate, Meldman Limited, Milwaukee, Wisconsin; former Tax Law Specialist in the Corporate Reorganization Branch, In- come Tax Division, Internal Revenue Service, Washington D.C.; member of the Ameri- can, Wisconsin and Milwaukee Bar Associations. t Editor's Note: This article was written prior to the effective date of the Tax Reform Act of 1976, Pub. L. No. 94-455, 90 Stat. 1525 (1976). MARQUETTE LAW REVIEW [Vol. 60:61 ciation, in the year paid or incurred.' As a result, the net income from the property is taxed to the owner at ordinary income tax rates even though he may have reinvested all the profits through improvements or payments on a mortgage. The only "shelter"' available to the individual owner from the property is the allowance for depreciation.' B. Corporate Ownership If a corporation which the taxpayer controls4 takes title to the property, the taxpayer has additional factors to consider. The particular facts and circumstances relating to each individual taxpayer will be determinative of which factors are fa- vorable and which are unfavorable. There are only two ways to transfer corporate funds from an operating corporation to its shareholders.' One way is to pay the shareholder money in the form of a salary in exchange for services rendered to the corporation by the shareholder in the capacity of an employee. However, a salary payment may only be deducted from the corporation's gross income for tax purposes if the salary paid is reasonable and purely for services. If the shareholder of the corporation did little or no work for which he was paid a salary, it would be difficult to justify the salary as reasonable and purely for services. Accordingly, an individual would have difficulty obtaining large amounts from the corporation in the form of salary if he did little else than obtain tenants, collect rent and perform infrequent mainte- nance. 1. The time for inclusion or deduction is determined by the taxpayer's method of accounting, either cash or accrual. 2. As used in this article, the term "shelter" means protection from some current income tax by means of deferral. 3. However, with the recapture of accelerated depreciation which causes some gain on the disposition of certain real estate to be taxed as ordinary income, even that shelter can be forfeited. See INT. REV. CODE OF 1954, § 1250, and discussion thereof infra at 73. 4. The term "control" is defined in INT. REv. ConE of 1954, § 368(c) as follows: For purposes of part I (other than section 304), part II, and this part, the term "control" means the ownership of stock possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of all other classes of stock of the corporation. 5. Subchapter S of the Internal Revenue Code is not available if more than 20% of the corporation's gross receipts constitute passive investment income. INT. REV. CODE OF 1954, § 1372(e)(5). 6. Treas. Reg. § 1.162-7 (1973). 1976] FEDERAL TAX CONSEQUENCES The second way to transfer corporate funds to individual shareholders is through the distribution of corporate earnings in the form of dividends. Such distributions are not deductible by a corporation but they are fully includible7 in its shareholders' gross income and taxable at ordinary income rates. If the individual shareholder needs the earnings generated from the property to pay his personal expenses, it would probably be better not to have a corporation take title to the real estate, thus avoiding payment of a corporate income tax in addition to a personal income tax. On the other hand, if the individual does not require current distributions, and he is in a high tax bracket, the lower corporate tax rates may justify having a corporation take title to the real estate. As a caveat, however, it should be noted that an accumulated earnings tax' may be imposed on corporations that unreasonably accumulate earnings for the purpose of avoiding income tax with respect to their shareholders.' Al- though further discussion of the accumulated earnings tax is beyond the scope of this article, it should be noted that in some instances, due to the different tax rates for individuals and corporations, an individual may fare better by having the corporation pay an accumulated earnings tax than by having it declare dividends.'0 Although tax considerations are important, one cannot lose sight of the nontax reasons for having a corporation take title to real estate. For example, during times of high interest rates it may become necessary for real estate investors to create a "straw corporation" in order to satisfy a lender who wants to bypass usury laws. 7. INT. REv. CODE OF 1954, § 116 provides for a $100 exclusion for dividends received from domestic corporations. 8. Id., § 531. 9. Id., § 532. 10. Peters & Beatty, Preventive Action to Avoid 531 Penalty: Recognition of Prob- lem, Possible Remedies, 20 J. TAX. 133 (1964); Hanson, Getting Capital Gains on Lump-Sum Payouts in the More Unusual Situations, 26 J. TAX. 158 (1967); Levy, McDowell, Price & Von Kummer, CorporateAccumulations: How to Meet the Prob- lems of Section 531: A Panel Discussion of Techniques and Issues, N.Y.U. 23D INST. ON FED. TAX. 745 (1965). 11. A "straw corporation" is a corporation created solely to hold property for its beneficial owner since that owner can only accomplish certain tasks in the corporate form. The use of "straw corporations" may result in the recognition of gain on the transfer of property both to and from the corporation. See Kronovet, Straw Corpora- tions: When Will They Be Recognized and What Should Be Done, 39 J. TAx. 54 (1973). See also Daniel E. Rogers, 34 CCH TAX CT. MEM. 1254 (1975). MARQUETTE LAW REVIEW [Vol. 60:61 C. Common Ownership In the case of a husband and wife, it makes no difference how title is taken for federal income tax purposes because income received from the property may be split between the spouses by their filing a joint income tax return regardless of how legal title is held. In the case of persons other than husband and wife, however, the type of tenancy ordinarily governs the income tax consequences. 1. Tenancy in Common In this type of arrangement, each tenant in common must report his proportionate part of the gross income from the property less his proportionate part of the deductible expenses at- tributable to the property. Even though one tenant paid a larger share of the total expenses than his proportionate share, he is allowed to deduct only his proportionate part measured by his interest in the property. Excess payments are treated as advances to his co-owners for which he has a right of reimburse- ment.1" Similarly, gain or loss on the sale of the property is allocated among the co-owners in proportion to their interests in the property, unless there is proof of actual ownership to the contrary."3 2.

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